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Monetary Policy Lessons and the Way Ahead

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Monetary Policy Lessons and the Way Ahead For release on delivery 12:20 p.m. EDT March 23, 2015 Monetary Policy Lessons and the Way Ahead Remarks by Stanley Fischer Vice Chairman Board of Governors of the Federal Reserve System at the Economic Club of New York New York, New York March 23, 2015 For over six years, the federal funds rate has, effectively, been zero. However it is widely expected that the rate will lift off before the end of this year, as the normalization of monetary policy gets underway. The approach of liftoff reflects the significant progress we have made toward our objectives of maximum employment and price stability. The extraordinary monetary policy accommodation that the Federal Reserve has undertaken in response to the crisis has contributed importantly to the economic recovery, though the recovery has taken longer than we expected. The unemployment rate, at 5.5 percent in February, is nearing estimates of its natural rate, and we expect that inflation will gradually rise toward the Fed’s target of 2 percent. Beginning the normalization of policy will be a significant step toward the restoration of the economy’s normal dynamics, allowing monetary policy to respond to shocks without recourse to unconventional tools. I would like to take this occasion to look back on some lessons learned during our time at the effective lower bound on the interest rate, and also to look forward.1 Monetary Policy since the Crisis Let me first take a step back in time. Prior to the crisis, the financial system was more fragile than we realized. Key vulnerabilities included excessive leverage, overdependence on short-term funding, and deficiencies in credit ratings, underwriting standards, and risk management. Importantly, interconnections across financial institutions heightened the risk of contagion through cascading losses. Some of these interconnections emerged from the use of complicated financial instruments that created seemingly safe and liquid assets. At the time, it was common to say that risk was being 1 The views that I offer are my own and not necessarily those of any other member of the Federal Open Market Committee or of the Committee itself. - 2 - dispersed and allocated to those best able to bear it. But rather than distributing risk widely, these instruments concentrated risk on the balance sheets of a relatively small number of highly levered financial institutions. As a result, as the subprime crisis developed, market participants pulled back from risk taking, leading to deleveraging spirals and fire sales.2 The damage spread across the globe. Following the collapse of Lehman Brothers on September 15, international trade collapsed as panic and financial connections transmitted distress across borders.3 Of course, the economy’s vulnerabilities did not stem from the private sector alone: in the public sector, gaps in the regulatory structure allowed important financial institutions to escape comprehensive supervision, and regulators were insufficiently focused on the stability of the system as a whole. The Federal Reserve responded aggressively to the crisis.4 By the end of 2008, the Federal Open Market Committee (FOMC) had reduced the target federal funds rate from 5-1/4 percent to, effectively, zero. The Fed also acted forcefully as the lender of last resort--in its traditional role of providing short-term liquidity to depository 2 For a model in which fire sales can arise from uncertainty about the network of cross-exposures among banks, see Caballero and Simsek (2013). 3 The fallout from the crisis was large even in countries that had not experienced an acute financial crisis. As an example, in six Asian countries, including China and India, exports fell more than 30 percent by the beginning of 2009, and industrial production declined about 10 percent. See the discussion of China, India, Indonesia, Malaysia, Thailand, and Taiwan in Coulibaly, Sapriza, and Zlate (2011). Regarding the role of credit conditions in the collapse of international trade, see Chor and Manova (2012). 4 A key trigger for the crisis was the decline in housing prices, which began in 2006 and led to uncertainty about mortgage investments. In the summer of 2007, two large financial institutions--The Bear Stearns Companies, Inc., and BNP Paribas Group--suspended redemptions from certain investment funds, perhaps marking the beginning of the financial crisis. In 2008, the crisis intensified with the near collapse of Bear Stearns in March and the bankruptcy of Lehman Brothers Holdings in September; a full-scale financial panic ensued across much of the global financial system. - 3 - institutions, and also by providing liquidity directly to borrowers and investors in key credit markets.5 In addition, the worldwide scope of the crisis called for concerted international action. Because of the global nature of dollar funding markets, the Fed authorized dollar liquidity swap lines with major central banks, beginning in December 2007. In October 2008, central bankers coordinated reductions in policy rates and the Group of Seven agreed to use all available tools to prevent the failure of systemically important financial institutions.6 The next month, the Group of Twenty announced a broad common strategy, including fiscal expansion. These steps likely prevented a second Great Depression, but they were not sufficient to avoid a severe global contraction. In the United States, with the federal funds rate at its effective lower bound by the end of 2008, the FOMC judged that it could not provide much additional accommodation via its conventional tool--reducing the federal funds rate.7 Instead, the FOMC used two unconventional tools: large-scale asset purchases and enhanced forward guidance. To varying extents, foreign central banks have also been using these tools. 5 In our role as lender of last resort, we worked closely with the Treasury Department and the Federal Deposit Insurance Corporation (FDIC). For example, to stem the run on money market funds, the Treasury provided a temporary guarantee and the Fed created a backstop liquidity program. In addition, the FDIC established the Temporary Liquidity Guarantee Program to guarantee certain unsecured liabilities of depository institutions and some bank holding companies. 6 On October 8, 2008, the Federal Reserve and five other major central banks jointly announced a reduction in policy interest rates. See Bank of Canada and others (2008). 7 A handful of central banks in Europe have recently set certain policy rates below zero. Specifically, the Danmarks Nationalbank, the European Central Bank, the Sveriges Riksbank, and the Swiss National Bank have set negative policy rates. In the United States, when the Federal Reserve sought to provide more accommodation despite the federal funds rate being, essentially, zero, we chose not to use negative rates, judging at the time that the small additional support for aggregate demand was not worth the accompanying risks to U.S. money markets and the intermediation of credit. - 4 - The Fed’s asset purchases did not have the conventional aim of increasing reserve balances to pull down short-term rates.8 Rather, purchases of longer-term securities lowered longer-term yields through portfolio balance effects. The evolution of our asset purchases reflected a learning process for policymakers. In the early programs, the FOMC specified the expected quantities of assets to be acquired over a defined period. In contrast, with QE3 (the most recent round of quantitative easing, implemented from September 2012 to October 2014), the FOMC announced that we would continue to purchase securities at a certain monthly pace until the outlook for the labor market improved substantially in a context of price stability. Later, the FOMC noted that the pace of purchases was also data dependent, allowing the pace to be revised based on its assessment of progress toward its long-run objectives. With the federal funds rate near zero and the Fed creating and adjusting new asset purchase programs, it became difficult for the public to anticipate how the FOMC would likely conduct monetary policy and respond to changing economic conditions. Thus, the FOMC began to rely heavily on enhanced forward guidance to communicate its intentions. Forward guidance works in part because it also constrains the flexibility of decisionmakers when the time comes to make their future decisions.9 8 Indeed, the maturity extension program--also known as Operation Twist--did not increase reserves at all. 9 There is a long literature in monetary economics about time inconsistency. Time inconsistency is the notion that, to achieve good outcomes, a central bank may need to make commitments about how it will act in the future--commitments that must be credible but that, ex post, the central bank might find hard to follow through on. For canonical papers, see Kydland and Prescott (1977) and Lucas and Stokey (1983); see also Fischer (1980). The early literature focused on the inability of central banks, in normal times, to commit to high future interest rates and low inflation. Interestingly, at the zero lower bound, central banks may face nearly the opposite commitment problem: To escape a liquidity trap, a central bank may want to commit to keep interest rates low and accommodate an output boom even after the headwinds from a crisis have dissipated. See, for example, Eggertsson (2006) and Werning (2012). For additional discussion of Federal Reserve communications, see Yellen (2012) and Stein (2014). - 5 - Nonetheless, a number of potential costs might be associated with unconventional tools. When interest rates are extremely low, risks to financial stability might grow. In addition, elevated securities holdings could reduce the Fed’s income and remittances to the U.S. Treasury when rates eventually rise.10 Further, the Fed’s quantitative easing appeared significantly to affect foreign asset markets, and to have contributed to a surge of capital inflows to emerging-market economies (EMEs).11 Our asset purchase programs were even called a “currency war.” However, eventually, most EMEs seemed glad to receive those flows.
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